China's Peg was America's
Crutch

Peter Schiff
July 28, 2005

One week after China's decision
to scrap its dollar peg, the Bank of China has already back-
peddled, warning currency traders not to expect any further appreciation
of the yuan. This rhetoric seems at odds with last week's announcement,
in which China revealed that the yuan, now pegged to a secret
basket of currencies, would be allowed to appreciate as much
as .3% per day. While .3% may not sound like much, in the foreign
exchange world it's huge. If repeated daily, it amounts to over
2% per week, 8% per month, or over 100% per year. With leverage,
buying the yuan could be the trade of a lifetime. No wonder Chinese
monetary authorities are trying to discourage speculators.

However, despite official warnings
to the contrary, the yuan will likely rise much higher than its
initial 2.1% revaluation. In fact, upon reflection, it appears
that China's currency peg recently acted as America's economic
crutch. The initial reason for the peg was to create confidence
and stability in the yuan, by pegging it to the stronger dollar.
During the Asian economic crises in 1997, as currencies throughout
the region plunged, the yuan held firm. During the "king
dollar" days of the late 1990's, as the tech bubble and
"new era" psychology propelled the dollar higher, the
yuan went along for the ride. It was only in the post-tech bubble
days, that the peg became an anchor, acting not as the floor
it was designed to be, but as a ceiling.

The reality is that it is not
the yuan that needs a peg, but the dollar. It makes no economic
sense for a nation to restrain the appreciation of its own currency.
A rising currency means increased purchasing power, lower interest
rates, and a rising standard of living. It is the market's way
of rewarding a nation for its enhanced productivity. China's
refusal to partake makes no sense whatsoever. Offering these
fruits to Americans instead makes even less sense. My guess is
that despite its claims to the contrary, China finally understands
this reality, and has adopted a "strong yuan policy."
However, unlike America's farcical "strong dollar policy,"
China's policy actually has teeth.

Contrary to government and
Wall Street rhetoric, an appreciating yuan is not good news for
America, or its financial markets. Maintaining the peg forced
China to extend enormous subsidies to both American consumers
and borrowers. Now that the peg/crutch is gone, the subsidies
soon will be as well. In the global auction for scare resources
and consumer goods, Americans will eventually be out-bid by increasingly
wealthier Chinese.

Some have incorrectly argued
that a rising yuan will make American exports more competitive
in China, and therefore benefit our economy. Such a simplistic
analysis is flawed, as its proponents fail to comprehend the
basics of international trade. The only reason our exports become
more competitive is that we will be selling them for fewer yuan.
In other words, we will now be forced to pay the Chinese more
yuan to purchase their products, but in return receive less yuan
for the products we sell them. The bottom line is, paying more
and getting less is a bad deal for Americans.

In addition, within minutes
of China's announcement, Malaysia revealed that it too had abandoned
its dollar peg in favor of China's basket strategy. In fact,
China's announcement basically gives all Asian central banks
the green light to sell their dollars as well. The ultimate implications
for Asians and Americans are enormous. For Asians, it means greater
purchasing power, higher real incomes, and rising standards of
living. Asian citizens, particularly the Chinese, will no longer
have their own purchasing power suppressed by their governments
and transferred to Americans. They will finally be able to enjoy
the fruits of their own labor, savings, and productivity.

For Americans, the opposite
will be true. This change will result in reduced purchasing power,
lower real incomes, and a falling standard of living. The Chinese
will no longer be subsidizing American consumers and borrowers
with low import prices and interest rates. Without these supports,
consumer prices and interest rates will rise, credit and the
economy will contract, stock and real estate prices will fall,
service sector jobs will be lost, the federal budget deficit
will worsen, and the dollar's decline will accelerate.

Specifically, the race to get
out of dollars is also a race to get out of treasuries, mortgage-backed
securities, and any other U.S. dollar-denominated debt. When
the largest buyers of U.S. debt stop buying, or worse yet start
selling, interest rates could sky rocket. As credit contracts
and interest rates surge, home prices will plunge, wiping out
trillions of dollars of paper equity for millions of American
homeowners. However, while the equity will vanish, the mortgage
debt will not only remain, but be that much more costly to service.
Imagine the implications for the U.S. economy and dollar-denominated
financial assets, should this financial nightmare become a reality.

Jul 28, 2005

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In addition, as the dollar's
value is likely to sink far faster than those of other fiat currencies,
investors can learn strategies to protect wealth and preserve
purchasing power by downloading my free research report on the
coming collapse of the U.S. dollar at www.researchreportone.com
and subscribing to my free, on-line investment newsletter at http://www.europac.net/newsletter/newsletter.asp.

Mr. Schiff is one of
the few non-biased investment advisors (not committed solely to
the short side of the market) to have correctly called the current
bear market before it began and to have positioned his clients
accordingly. As a result of his accurate forecasts on the U.S.
stock market, commodities, gold and the dollar, he is becoming
increasingly more renowned. He has been quoted in many of the
nation's leading newspapers, including The Wall Street Journal,
Barron's, Investor's Business Daily, The Financial Times, The
New York Times, The Los Angeles Times, The Washington Post, The
Chicago Tribune, The Dallas Morning News, The Miami Herald, The
San Francisco Chronicle, The Atlanta Journal-Constitution, The
Arizona Republic, The Philadelphia Inquirer, and the Christian
Science Monitor, and has appeared on CNBC, CNNfn., and Bloomberg.
In addition, his views are frequently quoted locally in the Orange
County Register.

Mr. Schiff began his investment career as a financial consultant
with Shearson Lehman Brothers, after having earned a degree in
finance and accounting from U.C. Berkley in 1987. A financial
professional for seventeen years he joined Euro Pacific
in 1996 and has served as its President since January 2000. An
expert on money, economic theory, and international investing,
he is a highly recommended broker by many of the nation's financial
newsletters and advisory services.